The Complications of Contingent Consideration: “It Depends”

Contingent consideration (otherwise known as earn-outs) has been in the news lately, particularly in the world of pharmaceuticals. Valeant Pharmaceutical’s continued bids for Allergan, Inc. (see here and here) include possible consideration of up to $7.6 billion, depending on the performance of drugs still in development. The full $7.6 billion payout would increase the total purchase price by 14% to 15% (as of this week – further refinement of offers by Valeant could change the ultimate impact of the contingent payment on the purchase price). Teva Pharmaceutical’s acquisition of Labrys Biologics, Inc. also features a hefty potential payout. While the initial upfront payment is $200 million, the purchase price could increase by up to $625 million dependent on the achievement of various milestones. The dependence of earnings on successful drug development (Labrys’s LBR-101 migraine treatment is expected to reach sales of over $2 billion if it gets to the market) makes contingent consideration particularly important in the pharmaceutical industry.

From the acquirer’s perspective, contingent consideration functions as a hedge against poor future performance and the possibility that cash flow will not grow as much as projected. Additionally, it can serve as incentive for a seller to maintain or improve the performance of the company after a transaction. Contingencies may be event-related – for example, a drug receives FDA approval. Other earn-outs are market-related – the acquired company reaches certain sales or EBITDA benchmarks. Event-related contingencies are generally independent of the overall market and are therefore free of systematic risk. Such contingencies are still subject to credit risk, which must be estimated by an appraiser.

ASC 805 requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, with the effective result of increasing the amount of goodwill in the transaction. This liability must be revalued annually until the contingency is resolved. The valuation of contingent liabilities is dependent on the probability of reaching various milestones at points in the future and is usually determined by probability-weighted expected future payments. The terms and complexity of the contingency can have a significant effect on the valuation process. Relatively simple considerations (i.e. involving multiples of EBITDA) may involve only a single-scenario model. Meanwhile, complex earn-outs involving various multiples, thresholds, or caps require more developed techniques, including Monte Carlo simulations or real options analyses. The appropriate method to use depends on the unique characteristics of the particular contingency.

As we’ve written before, there is no one-size-fits-all approach to contingent consideration valuation and it can be beneficial to have a valuation expert involved in your purchase price allocation process. We are well-versed in the various methods of valuing contingent consideration, and our work is routinely reviewed and accepted by the Big Four and other large accounting firms. We’d be more than happy to help you determine how your purchase price depends on the terms of your contingent consideration.